In previous posts here and here it was proposed that banks not become too interconnected or too big lest they fail and bring down the entire system. Mark Thoma advocates a reprivatization where banks are not allowed to get too big. It may be time to contemplate on how we got to where we are.
Back in 1994, there were economists who considered the U.S. banking sector to be too inefficient. (See for instance, Wheelock and Wilson, 1994.) As a result of low efficiencies and low profits, banks began adopting newer technologies and by 2001 improvements in bank profits became clearer. (See for instance, Berger and Mester, 2002.) Moreover, the push toward profit maximization also began to drive mergers. Akhavein, Berger and Humphrey (1997) finds that mega-mergers increased bank profits.
The conclusion that can be drawn from these (albeit short survey of) findings is that technology progress and profit maximization have driven bank mergers. Mergers can be treated with antitrust regulation and it is here perhaps that there may have been too little regulation. However, the failure may not have been the lack of regulation per se but the lack of a criteria for evaluating bank mergers. Antitrust regulators are concerned with whether mergers would have adverse effects on the services for consumers not the possibility of systemic risk. While the Fed and Treasury may also be required to sign off on these mergers then it is they who should be responsible for enforcing some kind of too big to fail or too interconnected to fail policy.
What about the case of a bank adopting an expensive technology that can only be profitable with scale economies, i.e. where mergers are the only option of becoming more efficient? An example would be economies of scale from combining IT departments. Should such mergers be disallowed? What if a bank developed a new technology that allowed it to become more competitive and grow from within? Should its growth be curbed?
There have been precedents where large firms that have grown from some competitive advantage have subsequently been broken up, for instance, AT&T. However, AT&T was broken up for competitive reasons, i.e. market power over consumers. Some may argue that the reason for this break up was inconclusive and that regulators over reacted. The fact that AT&T has now grown large again through mergers is evidence that market forces provide a rationale for being large.
Unfortunately, economics has provided very little in terms of policy guidance. How big is too big? Should a bank with a competitive advantage be regulated more heavily because of its potential to become too big? These are only a few of the questions that economists need to address after breaking up all the big banks. What's to prevent some of these from becoming too big again?
If the lesson here is that financial institutions should not become too big then what is the lesson from the following paper Are Credit Unions Too Small? by Wheelock and Wilson (2008) that seems to call for deregulation of credit unions. Here is the abstract:
Since 1985, the share of U.S. depository institution assets held by credit unions has nearly doubled, and the average (inflation-adjusted) size of credit unions has increased over 600 percent. We use a non-parametric local-linear estimator to estimate a cost relationship for credit unions and derive estimates of ray-scale and expansion-path scale economies. We employ a dimension-reduction technique to reduce estimation error, and bootstrap methods for inference. We find substantial evidence of increasing returns to scale across the range of sizes observed among credit unions, suggesting that an easing of regulations on credit union membership or activities would lead to further increases in the size of credit unions.